“Disregarded entity” is a tax term. It refers to an entity that, as the name implies, will be disregarded — or ignored — for federal income tax purposes.
The most common disregarded entity for federal income tax purposes is the single-member limited liability company (SMLLC). Unless the single member elects otherwise, the IRS disregards the LLC as an entity separate from its owner, and the owner reports the LLC’s income and deductions on the owner’s federal income tax return. In most cases, this is done by using Schedule C.
Taxation of a single-owner business
A single individual who owns a business has a few choices in how to own and operate the business. A single individual can own the business in his or her own name as a sole proprietorship, form a single-member LLC, or establish a solely-owned corporation. There are many factors that go into the decision of which structure to use, one of which is how the business’ income is taxed for federal income tax purposes.
Sole proprietorship
In the case of a sole proprietorship, there is no separate entity so the business’ income is the individual owner’s income and is reported on Schedule C.
Corporation
A solely owned corporation may be taxed as a separate legal entity and pay taxes on its income. This is referred to as being taxed as a C corporation.
Or, if the shareholder wants, and the corporation meets the requirements, it can be taxed as an S corporation, with the corporation’s income “passing through” to the shareholder.
LLC
The owner of a single-member LLC has a choice. By default, the LLC will be classified by the IRS as a disregarded entity. This means the LLC will be treated for federal income tax purposes as if it was a sole proprietorship. If the owner wants to, however, he or she can elect to have the LLC taxed as a corporation, in which case the LLC is not a disregarded entity.
If you’re interested in forming a single-member LLC that will be a disregarded entity for income tax purposes, consider the following pros and cons, and rules and regulations. We’ll also explore what’s involved in forming an SMLLC that will be a disregarded entity.
What are the advantages and disadvantages of a disregarded entity?
Simpler filing process
A considerable benefit of a single-member LLC being a disregarded entity is that it makes the tax filing process more straightforward than it is for corporations. For example, a corporation’s sole shareholder must file a separate return for the corporation in addition to his or her personal tax return.
An LLC has limited liability
A significant advantage the LLC has over the sole proprietorship is limited liability. It is important to recognize that an LLC is a disregarded entity only for income tax purposes. An LLC is an entity with its own existence for all other purposes. The LLC statute under which you formed your LLC says that it is a separate entity and is liable for its own debts and responsibilities.
The sole member is not liable and the creditor of the LLC must look to the LLC. The same is not true of a sole proprietorship. A sole proprietorship is not formed under a statute and has no legal existence at all. The business’ debts are the owner’s debts.
LLCs and corporations are very different entities
The choice of a corporation or an LLC involves a number of factors in addition to taxation. For example, an LLC is generally considered easier to manage. But, it can sometimes be easier for a corporation to obtain financing.
LLCs are not disregarded for other tax purposes
It is also important to remember that a single-member LLC is a disregarded entity for income tax purposes. It is not disregarded for other tax purposes, such as having to pay employment tax, franchise tax, sales tax, or excise tax.
This should also be taken into account because, for example, corporations and LLCs are treated differently when it comes to self-employment taxes.
Is a single-member LLC automatically a disregarded entity?
A single-member LLC is automatically classified as a disregarded entity by the IRS.
However, the LLC can elect to be treated as a separate entity by filing Form 8832 (Entity Classification Election) with the IRS.
Does a single-member LLC need an EIN?
An EIN is not required unless you have employees or file excise tax returns.
However, you may need to obtain an EIN for other reasons, such as opening a business bank account in the name of your LLC. Furthermore, some companies will require you have an EIN before they can process payments on your behalf.
Can a multi-member LLC be a disregarded entity?
A multi-member LLC is not a disregarded entity. An LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 (Entity Classification Election) and elects to be taxed as a corporation. It will also have to file Form 1065, U.S. Return of Partnership Income.
However, if the LLC is co-owned by a married couple who resides in a community property state, they can treat their jointly-owned business as a disregarded entity for federal tax purposes, if:
- The LLC is wholly owned by each spouse as community property under state law
- There are no other owners reported on federal tax returns
- The business is not considered a corporation under federal law
How your single-member LLC becomes a disregarded entity
The IRS automatically considers a single-member LLC to be a disregarded entity. As such, there are no steps to be taken to have your LLC classified as a disregarded entity for income tax purposes.
Come tax time, the IRS will not treat your LLC as a separate entity from you. As such, the LLC’s profits, losses, and credits should be captured on your individual federal tax return.
Learn more about creating an LLC in a few simple steps and get trusted guidance to make sure the process is done right.
Resources